It is little wonder investors become fearful. In recent times we have seen political jabbering from the US and ongoing tensions in many other pockets of the world – not least in north-east Asia and the Middle East.
This fear can trigger behavioural biases that can impact investors’ portfolios. But the reality is that geopolitical change is extremely difficult to predict - Brexit, the US elections and the recent calm on the Korean peninsula are all fine examples of this. Many people wrongly predicted the outcome of these events, and furthermore, wrongly predicted the impact on investment markets.
There are four ways investors typically handle geopolitical risks, and some of them are more advisable than others.
Predict and Gamble
Investors may try to predict the outcome of a geopolitical tension and then guess the impact this will have on investment markets. If done successfully, it can make them seem to be a money-making master.
But, more often than not, people get it terribly wrong. Positioning portfolios on this basis is a very dangerous game that is unlikely to align with investor goals.
Protection First
If in doubt, some investors prefer to sit out and wait. This is loss aversion in action. If the worst-case scenario prevails, they feel like a conservative genius, having protected capital during the dark turning point. However, the problem with this approach is that the market is always throwing potential curveballs.
An investor who avoids the market on the basis of any potential event-risk could end up sitting in cash on a semi-permanent basis.
This approach can be the most dangerous of all, with inflation further eroding cash returns and implying that one would be better off holding on and riding through short-term volatility.
Trying to Hold Tight
A buy and hold mentality acknowledges an inability to predict and adheres to a long-term mindset. This is far superior to the prior two approaches, not least because it keeps costs and turnover low, which are admirable traits that will ultimately benefit long-term investors.
Yet, investors are inherently bad at it. Specifically, evidence suggests investors are susceptible to change amid market panic.
No-one likes to lose 50% of their nest egg and that can move investors into the ‘protection first’ mode noted above. This tends to exacerbate any downturn and subsequently creates the potential for further mispricing opportunities.
Think about Valuations
The final approach is to consider the impact any geopolitical risk would have on the intrinsic value of investment markets and monitor the difference between price and that fundamental baseline. This is akin to the “Mr Market” analogy endorsed by Benjamin Graham and Warren Buffett, where an emotional human can often sell at prices that don’t reflect the underlying value. This approach is logically sound, however requires a rational framework and enforced discipline.
Which is Best?
It should be no surprise that we advocate a combination of the latter two approaches. This helps investors to control their behavioural urges while concentrating their analysis on what matters most.
If done correctly, investors can recognise that heightened geopolitical tension is unlikely to materially shift the underlying fundamentals, creating an opportunity to buy something for less than its worth.
The idea is to avoid action, except where it presents an opportunity, because fear-driven selling is rarely a good idea. It is much better to understand the different scenarios presented by geopolitical tension and the impact it may have on the long-term fundamental drivers. The benefit of this type of analysis is that it creates a fundamental baseline that can be used to monitor how far market prices are moving and whether a contrarian opportunity or danger presents itself.
